International Oil And Gas Joint Ventures In Emerging Markets

Monday, November 26, 2012 - 16:06

As growth continues to prove elusive in developed markets, multinational companies (MNCs) in the oil and gas sector are increasingly expanding into emerging markets. This trend has been accelerated by significant new discoveries of reserves, particularly in Africa.

Such jurisdictions can be challenging, so MNCs must discover the best model for structuring their investments. International joint ventures (IJVs) between domestic companies and MNCs remain an effective way of accessing such new markets and distribution channels. An IJV fuses the MNC’s management expertise, advanced technology, capital for expansion and existing distribution networks with local partners’ established supplier base, market presence, political know-how, local facilities and land, and established employee base.

Increasingly, it is becoming a regulatory or contractual prerequisite to market access for an MNC to establish an IJV with a local company as a result of efforts by local regulators and national oil companies (NOCs) to achieve certain social and economic benefits, including MNC technology transfer, an increase in local supplier opportunities, build-out of local skills and creation of employment opportunities for nationals. 

Will The IJV Last?

The popularity of IJVs can mask their complexities. IJVs are hard to negotiate, and in practice they can perform unsatisfactorily and often prove unstable.

Common difficulties to overcome include shareholders’ different objectives, ownership structure, culture, skill sets, industry experience and management styles. Small or family-owned enterprises can make frustrating partners for MNCs because they do not always possess detailed expertise in relation to certain managerial or functional areas. Equally, an MNC can prove a frustrating partner by becoming bogged down by internal processes, leaving the IJV lacking the agility to respond quickly in a local environment and frustrating the local partner.

The local partner is likely to be considerably smaller than the MNC (unless the local partner is an NOC or similar), a difference that can have important consequences for operating the IJV. Early, rapid expansion of the IJV can require substantial capital infusions that the local partner may not be able or willing to provide. 

Furthermore, it is common practice for MNCs to assign managers to the IJV on a rotating basis (and often as expats), which may allow too little time for them to become fully effective or may lead to a perception of lack of continuity and alienating the local partner’s managers because of the MNC appointee’s perceived lack of understanding of or interest in the business and the country. 

Given that IJVs are intended to benefit from synergies of cooperation and mutuality, what are the problems that frequently arise when negotiating and operating IJVs in emerging markets?

Agreeing To The Deal

Most lawyers will say that the most critical element of getting the deal done is agreeing to the JVA. The JVA is the record documenting the commitment of the partners to making the IJV work, so a well-crafted agreement is vital.  A JVA needs to address:

Governance and control

Most MNCs approach IJVs intent on holding and maintaining control through equity ownership. It is not uncommon in emerging markets for local laws to require that the local partner must hold at least 51 percent of the IJV. Even when not legally required, local regulators and stakeholders may still require that a local partner hold a controlling interest as a precondition to market access. 

Having 51 percent ownership does not in itself guarantee control. Control is only one aspect of the governance structure, which will include other important elements such as ownership of key intangibles such as intellectual property and technology, and local and customer knowledge.  

The notion of governance can be broken down into rights to determine specific management issues – for example capital expenditures, dividend policies, agreement of and amendments to key contracts, hiring and firing, and product pricing variations.  An MNC minority equity holder can maintain operational control by utilizing contractual mechanisms that give it the right to determine decision making in such key areas, and by controlling (or consenting to) the dismissal and appointment of key management.

Other important control/governance issues relate to whether the JVA should contain provisions addressing potential changes of ownership in the IJV, and whether or not either party should be entitled to sell its interest in the IJV. Typically, each party agrees in the JVA not to sell its shares for a predetermined period of time (commonly termed a “lock-in”), and, when sales are possible, agrees to first offer its interest to the other party before agreeing to a sale to a third party.

Alternatively, put and call rights over the IJV’s equity can be utilized in the JVA, with reference to certain triggers for exercise (which may be linked to profit targets or other benchmarks, or may result from a breach by one or other party of material provisions in the JVA). MNCs often ask for “drag” rights, allowing the MNC to force the local partner to sell its interest if the MNC wishes to exit. This is a very sensitive area for local partners, who are typically wary of such provisions.

Compliance

For most MNCs selecting a local partner who understands and demonstrates in their own operations a meaningful commitment to compliance is fundamental.  In the context of negotiating a deal, the majority of MNCs will insist upon the application of stringent compliance and environment, health and safety (EHS) policies by the IJV in line with their own corporate policies, particularly in high-risk countries. This is usually a non-negotiable, given the broad nature of anti-corruption laws globally (discussed further below) and EHS laws.

Many MNCs will go further to insist on practical, tangible measures, such as the right to appoint the CFO, compliance officer, EHS officer and/or a controller of the IJV, as well as audit rights over the local partner and exit rights for serious compliance or EHS breaches by the partner. In practice, there is no substitute for spending time with a local partner prior to entering into a partnership to get to know their operations, meet their employees and see firsthand how they do business.

Dividend policy and other financial matters

Tensions often arise over dividend policy between the local partner and the MNC, with the MNC often taking a long-term view that emphasises growing market share, long-term value and supporting key customers in growth markets, whilst the local partner may be more interested in ensuring an immediate and steady stream of dividends for shareholders.

Valuation problems

One partner in an IJV may contribute a going concern or intellectual property; the other may be bringing “intangibles” such as local operational expertise, local know-how or land for the IJV to utilize in its operations.  Local partners may have a sense of how much their contribution is worth, which is not in line with typical MNC valuation models.  The local partner may have significant leverage in any valuation negotiations, particularly where a quick setup of the IJV is critical to being awarded key equipment or long-term service contracts. That said, experience shows that a realistic and balanced valuation yields the best results in terms of fostering a long-term partnership.

Management responsibility or independence

Studies by McKinsey & Company found that IJVs are more successful if they have strong independent management and mechanisms in place to protect the IJV's management from excessive parent company interference. 

In practice, attempts by the MNC to micromanage an IJV in a distant country are likely to prove difficult. A better strategy may be to set up clear operational parameters and delegate broad powers to the IJV management and then let the IJV’s management operate within these pre-agreed boundaries, reserving only certain predetermined matters to the board or shareholders.

Operational issues

An MNC often requires the IJV to operate in a complementary manner to its global network, not merely within the local market in which the IJV operates and on which the local partner is focused. The challenge for an MNC is finding the balance between preserving the integrity of its global networks yet being flexible enough to permit deviations to its preferred operating model so that it can respond effectively to local requirements.  Disagreements can arise over the following:

  • Non-competes.  Typically, the partners in an IJV will undertake to each other that they will not compete with the business of the IJV. MNCs with multiple business units, which focus on complementary products and services (e.g., oil and gas and power generation) may be reluctant to give a non-compete undertaking (unless it is extremely narrow) for fear that another business unit of the MNC may subsequently be unable to expand into that market as best suits its business strategy and with a partner of its own choosing.
  • Export rights. The MNC often wants to prevent the IJV from exporting products or services into markets that are already served by other manufacturing or service infrastructure in its global network. The local partner, however, often has a different perspective and may expect the IJV to expand into foreign markets including those in which the MNC already operates.
  • Materials and technology. The MNC may require the IJV to purchase raw materials or components from it or its preferred supplier, even if available cheaper locally (often for quality reasons). In addition, the MNC will wish to carefully assess which technologies it licenses, considering the territorial and product scope of the IJV, the level of IP protection in the jurisdiction, the IJV and partner technical capability and possible overlap with other partner facilities and MNC JVs.
  • Culture and compliance. IJV management is often drawn from different cultures, and misunderstandings can occur. Global enforcement of anticorruption laws is growing – and many of these prosecutions are connected to IJV transactions. The local partner may not understand the importance of such issues to the MNC partner and may feel insulted or patronized by the MNC’s attitude on this subject. Great sensitivity is required, although NOCs and local partners are becoming increasingly aware of these issues and what MNCs will require in this regard. Many apply similar standards already. In addition, local regulators are increasingly keen to demonstrate “best practice” in this area and accordingly are very supportive of efforts to improve compliance procedures generally.
Maturation Of The IJV

 The sustainability of any IJV depends on each partner’s willingness to remain flexible over the long term and to adapt to changing circumstances. If the MNC insists on total control and the local partner views the IJV as a commercial and/or technical partnership and not just a financial investment, then the IJV is unlikely to enjoy long-term success. Similarly, if the local partner overplays the importance of its own indispensability as a consequence of the regulatory necessity of having a local partner, MNCs will tire quickly and find alternatives. The challenge is to find and maintain the right partnering balance.

Conclusions

Although the optimum approach for success will vary depending on transaction and country-specific factors, there are some key lessons for MNCs undertaking IJVs in emerging markets:

Identify the right country.  Many emerging markets have great potential. However, even very large MNCs with extensive resources have to think strategically about which markets to enter and when.  IJVs established without sufficient commitment and focus are not likely to prosper and may damage important relationships with customers and suppliers.

Identify the right local partner.  Selecting the right partner is often the difference between success and failure.  A key factor to consider is whether the partner is already known and trusted as a result of prior dealings and/or has previous experience working successfully in a similar capacity with another foreign company or investor. It is also important to understand clearly the local partner’s objectives from the outset and be clear about one’s own objectives.

Identify key decision makers and build relationships directly. This is a critical factor, and it is especially important when dealing with a state-owned customer or a local partner in which the customer has an interest. An effective strategy is to engage the local regulator early and to share openly localization plans, including those with respect to partner selection and governance of the IJV. 

Deal with dispute resolution and exit. This point is not specific to IJVs in emerging markets.  Most joint ventures will ultimately end up in some form of dissolution or buyout.  It is essential that the JVA addresses these concerns in sufficient detail to address all possible outcomes. In addition, ensure that you have a contingency plan for the ongoing operation of the business post-termination on the IJV.

Make the JVA the foundation, but be flexible: The JVA is important, but recognize that it can be unhelpful to regard it as “set in stone. Changes in circumstances that may not have been envisaged by either party at the outset may necessitate changes to the JVA. In this regard, it is important to maintain an open and  direct dialogue between the partners at senior levels.

Marcus A. Young is a Senior Associate at King & Spalding and Jane Moffat is Associate General Counsel at GE Oil & Gas. These are the views of the authors and do not represent the views of the organizations for which they work.

Please email the author at myoung@kslaw.com with questions about this article.